Corporate Financial Planning
Introduction to Financial Analysis for Corporations
by George W. Blazenko
All Rights Reserved © 2008
Chapter 4 Corporate Financial Planning
“For the happiest life, days should be rigorously planned, nights left open to chance.” — Mignon McLaughlin (v. 1915?), U.S. author, editor, Atlantic (Boston, July 1965).
Chapter Four Contents
(4.1)Introduction
4.1.1 Cash Budgeting
4.1.2 Projected Financial Statements
4.1.3 The Value of Financial Planning
(4.2)Cash Budgets
4.2.1 An Example of Cash Budgeting
4.2.2 The Cash Budgeting Exercise
(4.3)Projected Financial Statements
(4.4)Financial Planning And Growth
4.4.1 Cash is King in Financial Planning
4.4.2 Trade Capital, Invested Capital, and Liquidity
(4.5)Financial Planning And Short-Term Debt
4.5.1 Example of Short-term Debt Planning
(4.6)Incremental Sales and Financial Planning
4.6.1 Incremental Sales and Short-term Debt
4.6.2 Sales and Financing in the Long-term
(4.7)Summary
(4.8)Suggested Readings
(4.9)Problems
(4.10)Solution End of Chapter Problems
(4.11)Chapter Index...... 206
(4.1)Introduction
One of the themes of this book is that the operating and financing activities of a firm are inextricably related. One aspect of this relation is that sales growth necessitates incremental invested capital that must be financed. In the short term, trade capital increases and in the long term, capital expenditures also increase. For example, if a firm has an invested capital turnover of 1.5, then every dollar increase in per annum sales requires (on average over the long term) an expenditure of $0.67 in invested capital. This expenditure is financed either by the sale of financial assets or implicitly through retained earnings.
There are two reasons that financial planning is important. First, financial planning helps to ensure that the returns earned by a firm from its business activity are adequate for financial asset-holders. Because the benchmark for an adequate rate of return is equivalent risk financial assets, financial market returns set the standard for a firm’s operating performance. Second, the sale of financial assets is neither instantaneous nor costless. A planned increase in sales which requires an increase in invested capital can be delayed or lost if financing has not been anticipated and plans are not in place for the sale of financial assets. In addition, investors will not seriously consider the financial assets of a firm that has inadequate plans for operating and financing needs. Well-defined plans help assure investors of the professional competency of managers.
In this chapter, we consider two important financial planning tools, cash budgeting and projected financial statements. A cash budget and projected financial statements share a number of important elements. First, both these planning tools begin with a forecast of future sales. Second, both require estimates of parameters and assumptions about financial relations. Third, principal assumptions, which influence the decision to be made, are typically set out at the beginning of the analysis. Last, reasonable variations in parameters and assumptions are typically made in order to determine the effect that these changes have on financing needs and on the financial health of the firm.
4.1.1 Cash Budgeting
In a cash budget, analysts predict future cash inflows and outflows. The cumulative effect of inflows and outflows on a firm’s cash balance is forecast and monitored so to ensure surplus cash is invested and that cash deficits are financed efficiently. The interval over which cash flow increments are predicted can be daily, weekly, or monthly. These intervals are relatively short because an important objective of a cash budget is to ensure that funds are available when needed to meet obligations and to maintain solvency. A cash budget is an operational planning tool because it is intimately related to the day-to-day operations of a firm. For smaller firms, start-up firms, growth firms, or firms having cash flow difficulties, a cash budget is an indispensable planning tool. For many small businesses, a cash budget is the only financial planning tool.
4.1.2 Projected Financial Statements
Projected financial statements (also known as pro-forma statements) are predictions of a firm’s future financial statements. As with a cash budget, the purpose of projected financial statements is to guide operations and to anticipate future financing needs. However, because projected financial statements are for a quarter, a year, or many years hence, they are associated more with long-term planning by a firm. Long-term plans are generally set out in a firm’s business plan, and therefore, projected statements are an important element of this document. A business plan is often used as supporting material for the sale of a firm’s financial assets to private investors.
4.1.3 The Value of Financial Planning
The true value of financial planning is not in the quantitative amounts arising from a model of a firm’s operating and financing activities. These amounts are based on estimates and approximations, which are unlikely to be realized. The value of financial planning is in the process of investigating possible consequences of a firm’s activities. In this investigation, a great deal is learned about the characteristics of a firm and about available opportunities. If this planning is not undertaken, these lessons and opportunities are missed. Financial planning is, in its best application, a focal point for organizational decision making. As part of this process, both qualitative and quantitative factors play important roles. Cash budgets and projected financial statements are important elements of this process but they cannot substitute for sound business judgment. Reliance upon financial planning tools that have been mechanically and thoughtlessly prepared is foolhardy.
(4.2)Cash Budgets
In this section, we use an example to illustrate the construction of a cash budget.
4.2.1 An Example of Cash Budgeting
Poitras Plumbing Supplies is a wholesale distributor of plumbing gear. Treasurer Tara Poitras wants to estimate her company’s cash balances for the last three months of this year, 1999. Use the following information to construct a monthly cash budget for Poitras Plumbing for October through December 1999. Do your results suggest the treasurer should concern herself primarily with choosing where to invest surplus cash or primarily with finding ways to borrow money?
Assumed Facts and Information
Wages are $60,000 per month, paid in cash. Dividends of $20,000 are to be declared and paid in November. An installment on taxes payable, in the amount of $65,000, is due in December. Assume the cash balance is $221,000 as of September 30, 1999. The minimum desired cash balance is $100,000. Poitras Plumbing borrows at the end of any month, if necessary, to bring their cash balance back up to $100,000. At least over the upcoming quarter, Tara has no plans to pay down short-term debt that might have accumulated, even if there is cash available beyond the minimum balance. Current short-term borrowing is zero. Tara has approved capital expenditures in the amount of $340,000 to be made on October 1. Poitras Plumbing earns interest on its cash balance at the rate of 12 percent per annum, compounded and paid monthly. Interest on short-term borrowing, in the form of an operating loan, is at the rate of 16% per annum, compounded and paid monthly. Operating loans are short-term financing arrangements that allow a firm flexible borrowing up to a maximum established credit limit. There are no predefined principal repayment schedules. Repayment is negotiated between the lender and the firm and depends upon the firm’s operations and cash flow forecasts. The lender usually reviews the loan, at least annually, after the receipt of financial statements. An operating loan is typically secured by a combination of accounts receivable, inventory, and personal guarantees. Poitras Plumbing does not plan to repay principal on their operating loan over the course of the upcoming quarter. However, monthly interest payments will be made at the rate of 16% per annum, compounded and paid monthly.
Poitras Plumbing makes monthly long-term debt payments of $5,738.84 per month. From October, 1999 through the fourth quarter of 2000, the decomposition of payments into interest and principal is shown in this amortization schedule:
Time Period / Interest / Principal / PaymentsOctober, 1999 / $4,000.00 / $1,738.84 / $5,738.84
November, 1999 / 3,982.61 / 1,756.23 / 5,738.84
December, 1999 / 3,965.05 / 1,773.79 / 5,738.84
First Qtr, 2000 / 11,788.01 / 5,428.51 / 17,216.52
SecondQtr, 2000 / 11,623.52 / 5,593.00 / 17,216.52
ThirdQtr, 2000 / 11,454.05 / 5,762.47 / 17,216.52
Fourth Qtr, 2000 / 11,279.44 / 5,937.08 / 17,216.52
Tara Poitras contacts the marketing department (headed by Sarah Poitras) for sales information. Sarah provides the following information. Realized sales for August and September and forecasted sales for October, November, and December are shown below:
Sales (20% paid in cash, the rest on 30-day credit terms)August (actual) / $140,000
September (actual) / 200,000
October (forecast) / 200,000
November (forecast) / 300,000
December (forecast) / 400,000
Tara also contacts the production and scheduling department (headed by Moe Poitras). Moe provides the following information:
Purchases (all on 60-day terms)August (actual) / $130,000
September (actual) / 130,000
October (forecast) / 195,000
November (forecast) / 260,000
December (forecast) / 100,000
4.2.2 The Cash Budgeting Exercise
The cash budget focuses on cash inflows and outflows. You should recognize that sales and purchases do not have immediate cash flow effects. Sales might be made on credit and, therefore, cash is not received until collections are made. Likewise, many purchases are on credit, so cash does not leave the firm until invoices are paid.
Use one of the following three worksheet links to prepare a cash budget for Poitras Plumbing.
If you would like to practice your skill at designing a cash budget “from scratch” use the empty worksheet on the left. In the middle worksheet there is a template for a cash budget in which you can develop the relations between the given cash budget cell items but you use your own spreadsheet formulas. Alternatively, you can simply review the completed cash budget in the worksheet on the right.
In your cash budget, you should find that Poitras Plumbing must borrow $212,529 in October and an extra $5,121 in December. Total incremental short-term borrowing for the fourth quarter of 1999 is the sum of these two amounts: $217,650. You should also find that in November, Poitras Plumbing forecasts a cash balance that is $2,427 above the minimum cash requirement. This is valuable information. Knowing that they will need to do some short-term borrowing over the course of the last quarter of the year, they can schedule a visit with the commercial loan officer in charge of their account at the bank.
(4.3)Projected Financial Statements
We continue the story of Poitras Plumbing from the preceding section to illustrate the use and construction of projected financial statements. A cash budget is not required to prepare projected financial statements, but in practice, it makes sense to construct them simultaneously. The juxtaposition of these two financial planning tools highlights the relation of one to the other.
Additional Assumed Facts and Information
Cost of goods sold consists entirely of purchase costs and is expected to equal 65% of sales. Selling and administrative expenses consist only of wages. Quarterly depreciation equals 3% of the declining balance of net fixed assets. Miscellaneous accruals are not expected to change.
Shown below in the next two exhibits are the income statement and balance sheet for Poitras Plumbing for the nine months ending September 30, 1999. These exhibits are embedded EXCEL worksheets, so you may double-click to edit them. We made space for you to complete the 1999 fourth-quarter projected financial statements. Using the assumptions given above and the cash budget prepared for Poitras Plumbing, finish the projected financial statements.
Note that on the balance sheet, fourth-quarter borrowing is labeled as the “PLUG” figure. With respect to this particular exercise, this value is the principal item of interest. What is the predicted short-term borrowing requirement for the fourth quarter of 1999? In preparing projected financial statements for Poitras Plumbing, you should use as much information as you can from the cash budget; these two planning tools should be consistent with one another.
Exhibit 4–1. Income Statement, Poitras Plumbing
In your projected fourth quarter statements, Sales should equal the sum of monthly sales for October, November, and December from the cash budget. Accounts Receivable should equal 80% of sales for December (recall that 80% of sales are on credit and that terms are net 30 days). Accounts Payable should equal purchases for November and December (all purchases are on credit and terms are net 60 days). As a check figure, you should find short-term borrowing required for the fourth quarter to be $217,650. This is the same value as shown on the cash budget, as it should be; two related financial planning tools should arrive at the same result.
Poitras Plumbing Solution: Click on the icon to see projected financial statements for Poitras Plumbing, and to see how these values are calculated.
Exhibit 4–2. Balance Sheet, Poitras Plumbing
(4.4)Financial Planning And Growth
4.4.1 Cash is King in Financial Planning
Many smaller firms feature a combination of rapid sales growth and owners with weak planning skills. Because growing firms have the greatest need for incremental investment, these firms are prone to liquidity problems unless they engage in financial planning. To meet cash obligations as they come due is not as easy as it might seem. For example, accounting information is not necessarily helpful in liquidity monitoring. Net income measures the increment in shareholder wealth (according to generally accepted accounting principles) arising from a firm’s operations. However, net income is not equal to cash flow and cash is required to meet the obligations of a firm. To ensure solvency, we must focus our planning on cash flow and not net income.
Firms with positive and improving net income can, nonetheless, have liquidity problems and liquidity problems are not restricted to firms with poor operating performance. In fact, firms with high sales growth often have the greatest need for incremental investment, and therefore, if cash is not monitored closely, liquidity problems arise. To illustrate that net income and liquidity are not equivalent, we present the following adaptation of a problem that appeared in the April 28, 1956 issue of Business Week.
How to go Broke ... While Making a Profit
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As the year starts, Mr. Jones of the ACME Co. is in fine shape. His company makes widgets – just what the consumer wants. They make them for $0.75 each and sell them for $1. By the end of a month, the marketing staff of ACME anticipates unit sales for the upcoming month and advises the production department so that a one-month supply of inventory sufficient for widget demand in the upcoming month is available. ACME pays its bills promptly, and bills customers 30 days net. Sales are right on target; and the sales manager predicts a steady increase. Mr. Jones feels that this is his lucky year; it begins this way:
Jan. 1: Cash $1,000, inventory $750, receivables $1,000, equity $2,750.
In January, ACME sells 1000 units, ships them at a cost of $750, collects receivables, and produces 1,500 units in anticipation of February sales. Profit for the month is $250. ACME’s books look like this:
Feb. 1: Cash $875, inventory $1,125, receivables $1,000, equity $3,000.
In February, sales jump as predicted to 1,500 units. January receivables are collected. February production is 2,000 units in anticipation of March sales. Profit for the month is $375. Mr. Jones feels confident that ACME is doing fine, because net income is rising. ACME’s books look like this:
Mar. 1: Cash $375, inventory $1,500, receivables $1,500, equity $3,375.
In March, sales jump as predicted to 2,000 units. The marketing department has a celebration party. February receivables are collected. March production is 2,500 units in anticipation of April sales. Profit for the month is $500. Mr. Jones feels giddy at the success of his firm; net income is rising!
As April 1 arrives, ACME seems to be running itself; Mr. Jones begins to plan for his vacation to the Caribbean. But suddenly, he gets a telephone call from his treasurer: “We’re out of cash! The suppliers can’t be paid! We need money.” The books have finally caught up with ACME.
Apr. 1: Cash $0, inventory $1,875, accounts receivable $2,000, equity $3,875.
A Rudimentary Financial Analysis of the Acme Co.
The title of the ACME problem in Business Week is somewhat misleading. ACME is not going broke; they do, however, have a liquidity problem arising from rapid sales growth. Expansion of their business activity requires incremental investment in trade capital. Because funds from operations are not sufficient to offset incremental investment in accounts receivable and inventory, and ACME does no external financing, the cash balance of ACME falls. What ACME needs is a little financial planning to ensure that cash is on hand when it is needed to pay suppliers. The following table lists the sources and uses of funds for ACME and a number of key ratios that measure operating performance.
Exhibit 4–3. How to go Broke . . . While Making a Profit
The fact that ACME has funds from operations not quite sufficient to cover incremental investment in trade capital does not imply that ACME should not make these investments. The rate of return on invested capital (ROIC) is increasing over time and it appears it likely would exceed a reasonable financial market determined opportunity cost for Mr. Jones. In other words, without doing a complete financial analysis, we can speculate that incremental investments by Mr. Jones are likely to be positive NPV investments, and therefore, they should be undertaken. These investments, however, are draining cash out of the company.